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November 26, 2012

Hussman: Market Needs to Fall by a Third Just to Get to Normal

Permabear portfolio manager says we are past the point where U.S. bull markets peak

In his latest letter to Hussman Funds investors, the former finance professor joins the fray of gloom-mongering characterized by Grantham’s letter, surprisingly taking the “optimists’ side.”

Grantham, and before him Research Affiliates’ Christopher Brightman and Northwestern University economist Robert Gordon, compiled data on population, employment and productivity all suggesting that U.S. economic growth has slowed to a new normal of around 1%.

Hussman has a different take on these trends. “My impression is that what Gordon and Grantham see as a precipitous decline in per-capita productivity and growth over the past quarter century is actually the product of distorted capital markets and misallocation of capital,” he writes.

Citing Nobel economist Robert Lucas, Hussman says the true long-term problem is a central bank that is set upon eliminating any short-term pain in the economy even at the cost of growth that correctly allocated capital would provide.

“… Lucas once calculated that the gain in economic welfare from an increase of just a fraction of a percent in long-term economic growth would exceed the benefit of entirely eliminating business cycle fluctuations,” Hussman (left) writes.

Yet while Hussman is an “optimist” in the sense that a differently managed Fed might in theory improve the economy’s long-term growth prospects, the main thrust of his letter is that in the short-term, at least, the stock market is doomed based on valuation fundamentals, correctly understood.

Hussman critiques a seemingly “benign” P/E ratio based on forward operating earnings he argues cannot be sustained. Rather, his analysis is based on metrics such as revenue, book value, dividends and cyclically adjusted earnings (i.e., the Shiller P/E) that do not fluctuate strongly based on the business cycle.

On that basis, Hussman warns the market is valued some 40% to 70% above “pre-bubble valuation norms,” a danger since bull markets tend to peak when they reach 30% to 50% above these norms.

“Unless we assume that valuations will remain rich forever, this doesn’t portend well for returns going forward,” he writes.

Hussman says today’s rich valuations are the legacy of the late ’90s bubble, which have produced 14-years of returns that have underperformed treasuries. But these valuations have not come down to earth during that time, merely climbing down from “bubble” levels to “rich” levels.

To illustrate this point, Hussman notes that Shiller P/Es below 12 have been associated with subsequent annual returns averaging 15% over the next decade whereas Shiller P/Es of 22 or higher have been associated with subsequent annual returns averaging 3.6% over the next decade.

Hussman says the current multiple is 21.2 and adds, ominously: “With little respite, the Shiller P/E has been above 22 since 1995, and the average Shiller P/E since that time has been over 27.”

Hussman concludes: “A fairly run-of-the-mill normalization of valuations in the course of the present market cycle would imply bear market losses of about one-third of the market’s value, without even establishing significant undervaluation.”